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Forbes.com

Is Bigger Better? Three Ways Utilities Can Benefit from Scale

Is Bigger Better? Three Ways Utilities Can Benefit from Scale

Utilities executives must find other ways to deliver on the earnings growth targets that shareholders expect.

  • 2 juin 2016
  • min

Article

Is Bigger Better? Three Ways Utilities Can Benefit from Scale

This article originally appeared on Forbes.com.

Utilities in developed markets can no longer depend on the steady growth in demand for electricity that made them a reliable long-term performer for decades. Greater energy efficiency, distributed generation and a post-recession shift to less energy-intensive industries all combine to flatten out demand for electricity in North America and Western Europe. Without the steady demand growth that they used to depend on, executives must now find other ways to deliver on the earnings growth targets that shareholders expect, and scale is near the top of the list.

Mergers and acquisitions are one of the most visible ways to gain benefits from scale, whether from merging across borders, acquiring gas local distribution companies or building up the power generation portfolio.

But compared with other industries, utilities have a difficult time capturing these synergies. Sometimes regulators ask them to maintain two different headquarters (one in each region) before agreeing to a merger, or they require that any savings from the deal are returned to ratepayers.

For utilities, the total value of scale doesn’t come just from familiar synergies such as combining back-office functions. It mostly comes from developing a scale platform and tapping a broad range of benefits, including not only traditional cost benefits but also a wider application of repeatable processes and more effective use of capital.

Traditional benefits. Acquisitions in neighboring regions offer some opportunities to combine operations, but those savings might be relatively small since these operations make up a small part of most utilities’ operating costs. Sometimes utilities can’t merge field operations because the territories aren’t next to each other. Mergers can also help reduce administrative costs, but since these are also a small share of operations, the effect may be minimal.

Even more opportunity, however, comes from two other aspects of scale: repeatability and capital deployment.

Repeatability. Utilities that have developed a competitive advantage through their repeatable models can extend these models when they acquire other companies, vastly increasing the scale benefits. Opportunities for repeatable models include investment decisions and deployment practices for new technologies (such as advanced metering infrastructure or distributed management systems) and standardization of the processes that field forces use. Wholesale energy supplier NextEra has built one of the largest renewable portfolios in the US with repeatable practices for identifying attractive niches (such as those with existing transmission capacity) and scale benefits in buying equipment like turbine blades. These models help NextEra identify good deals and attractive power purchase agreements.

Capital deployment. Scale allows larger companies to assume greater risks—risks that would be “bet the company” moves for smaller firms, which would need to devote a greater percentage of their operating cash flow to the integration. For example, Duke Energy, Southern Company and Dominion have all made adjacent moves into gas distribution that carry an acceptable level of risk for each of these very large, vertically integrated utilities but would be much more difficult for smaller competitors to take on.

Bigger companies can also make better use of tax incentives. For example, the extension of both the production tax credit and investment tax credit in late 2015 created tremendous value for companies that can develop large power-generation facilities from solar and wind. Smaller companies with lighter tax burdens might not be able to take full advantage of these incentives, but larger companies can. For example, Berkshire Hathaway Energy has built a significant, unregulated large-scale renewable portfolio based on its ability to benefit from related tax incentives.

Of course, developing a scale platform and successfully executing at scale is a labor- and capital-intensive process that has a greater chance for success when a company is already operating near full potential in its core business. Before pursuing greater scale, executives should first tend to any easier and less expensive ways to unlock value. Are you taking advantage of all available efficiencies in your current organization? Is your core business operating at full potential? Could you take advantage of investment opportunities in your current grid or power plant portfolio, without the need for acquisitions?

Executives also need to be sure that their scale ambitions can withstand a range of potential scenarios. In the early 2000s, the EU’s utility sector experienced consolidation along the same lines as we see in North America today. This trend resulted in several very large, cross-border utilities that were successfully outperforming their mid-tier rivals—until the EU’s regulatory landscape shifted dramatically to encourage and reward investment in renewable sources such as wind and solar. Scale did not protect these large EU utilities from the influx of capital into smaller, agile, distributed energy start-ups.

For executives across the utility ecosystem, building a scale platform will become increasingly important as they try to deliver against shareholder expectations while the underlying economics of the industry shift. The sector is likely to experience further consolidation—and executives will need to make sure that their skills in deal making and post-merger integration are up to the task. Equally important will be their ability to create benefits from their scale platform, far beyond the simple cost efficiencies that drive M&A in most other industries. They will need clarity about how they intend to generate value from scale, and they will then need to build the internal capabilities necessary to support the scale platform.

Aaron Denman is a principal with Bain & Company in Chicago. Jason Glickman is a partner in Bain’s San Francisco office. Jim Wininger is a Bain partner in Atlanta.

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